Why SBI chief is all wrong in his understanding of CRR

By Shanmuganathan Nagasundaram

Maybe a “zero virus” is at work. First, it was Kapil Sibal who propounded the “zero-loss theory” for the loss incurred in spectrum allocations. As if that wasn’t enough for the Congress to learn its lessons, it was P Chidambaram’s turn next to propose another “zero theory”-this time for the even greater loss incurred in coal mines allocation.

Just when we thought that the zero virus was limited to politicians, the State Bank of India (SBI) Chairman propounded another “zero theory”-this time espousing the cause of zero cash reserve ratio (CRR). Absurd enough as the first two zero theories are, even though not as obvious, the third one proposed by the SBI Chairman easily outranks the other two.

However, some historical background on the nature of banking would be required to understand why this is the case. Banks were, and even today ought to be, essentially warehousing operations. The notes issued when banking first came into being were deposit receipts against claims on money (i.e. gold or silver) stored in these warehouses and these notes were 100 percent redeemable against physical bullion.

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[caption id=“attachment_436645” align=“alignleft” width=“380”]  Any person could walk into a bank and exchange the dollar or pound sterling bill for the said amount of gold bullion.PTI[/caption]

For example, one US dollar represented a claim against one-twentieth of an ounce of gold. Other countries also had similar denominations-i.e. the pound sterling was defined as one-fourth of an ounce of gold.

Any person could walk into a bank and exchange this dollar or pound sterling bill for the said amount of gold bullion. This was the case for nearly 150 years prior to 1913 (ie, till the formation of the Federal Reserve).

But bankers being bankers, a few crooked ones figured out that they could issue more notes than the physical bullion they held as the process of redemption by their clients was never overwhelmingly large.

This was the origin of fractional reserve banking (what we call cash reserve ratio in India). In general, most banks of that era operated with a 40 percent CRR. It was when bankers got even greedier, we had the situation of loss of confidence and bank runs.

When the Federal Reserve was formed, only 40 percent of the currency issued was backed by physical bullion. The rest had still to be backed by bill of credit and other instruments, but the “gold standard” was irretrievably damaged with the formation of the Federal Reserve.

Even after this, however, the suspension of free convertibility of currencies into money was not an overnight occurrence. This happened through a series of gradual steps -temporary suspension during World War-I, Franklin D Roosevelt’s confiscation of private gold during the Great Depression of the 1930s, the Bretton Woods agreement that outlawed conversion for individual citizens while still permitting conversion for other central banks, and finally with Nixon closing the gold window in 1971 (he said it was temporary, but even after 40 years we are yet to see the reopening of the gold window).

These days, however, redeemability is not even in the realm of possibility for citizens and that’s really been the case since the Bretton Woods agreement in 1944. That said, only an intellectually inane banker would argue for a completely unbacked paper money system. This is what the claim of zero CRR essentially means.

So even though currencies today represent “unbacked liabilities of bankrupt governments”, a semblance of sanity is maintained through the pretence of CRRs. With central banks operating in such an intellectually embarrassing scenario, what the SBI Chairman said is the equivalent of Bernie Madoff declaring proudly from the rooftop that he is running a Ponzi scheme. No wonder, the normally demure Reserve Bank officials (no angels themselves, incidentally) responded with a rather sharp rebuttal.

So why did the SBI Chairman make such an observation? Only two possibilities - one, he is clueless about the nature of money, banking and why the practise of CRRs is in place. Or two, he wants to indulge in a grandiose swindle (zero percent CRR indicates a theoretically infinite money supply) on the scale of what John Corzine did at MF Global. My guess is that it’s the former, but either scenario doesn’t bode well for the future of depositors in the country, coming as it does from the head of India’s largest bank.

So, with the current fractional reserve banking system, even the best of banks are always under the threat of a bank run. They can never fulfil the claims of even 10 percent of their depositors if they make a claim for even paper currency. So why has such a system survived this long? This can only be answered with a rhetorical question-why did Greece survive this long even though it was just as bankrupt three or four years back.

Just as the bond vigilantes were asleep in the Greece scenario, depositors are asleep in the banking scenario. For sure, they will wake up one day. And the only way to avert a bank run then would be massive inflation of the currency by central banks.

So what should the ideal CRR be? In an honest bank, there ought to be a clear distinction between savings and current (or “on demand”) deposits. With current accounts, anything less than 100 percent CRR is a Ponzi scheme and it’s up to each society to decide what levels of fraudulent banking they would tolerate.

That said, with the state of technology we have today, it should be much easier to implement a 100 percent reserve banking system. And it’s only the money held under savings deposits that is available for issue of loans. That was the way honest banks operated prior to the formation of the US Federal Reserve and that’s the way they will operate in the future when the current fiat currency regime collapses.

Shanmuganathan “Shan” Nagasundaramis the founding director of Benchmark Advisory Services - an economic consulting firm. He is also the India Economist for the World Money Analyst_, a monthly publication of_ International Man_. He can be contacted at__ shanmuganathan.sundaram@gmail.com_